Chapter 27: Developing and investment strategy (1)

Question 1

Principles of investment

Answer 1

A provider should select investments that are appropriate to the:

• nature
• term
• currency
• uncertainty wrt timing & amount

of the liabilities

• and the provider’s appetite for risk.

Subject to this, the investments should be selected to maximise the overall return (income plus capital) on the assets.

Question 2

In practice, the actual liability outgo depends on (2)

Answer 2

• monetary value of each of the constituents

- probability of it being received or paid out.

Question 3

Liability outgo can be split by nature into 4 categories:

Answer 3

• guaranteed in money terms
• guaranteed in terms of a prices index or similar
• discretionary (with-profit discretionary benefits)
• investment-linked (unit-linked benefits)

Question 4

Investment-linked benefit payments (i.t.o A/L matching)

Answer 4

Appropriate assets are those which replicate, or closely approximate the index.
Any free assets may be used to maximise returns with any profit benefiting the provider. However, regulation may disallow mismatching.

Question 5

Currency (i.t.o asset-liability matching)

Answer 5

Liabilities denominated in a particular currency should be matched by assets in the same currency, so as to reduce any currency risk.

Question 6

Regulation (i.t.o. investing assets)

Answer 6

• Types of assets:

• Restrictions on the types of assets that a provider can invest in
• Restrictions on the amount of any particular type of asset that can be taken into account for the purpose of demonstrating solvency.
• A requirement to hold a certain proportion of total assets in a particular class, for example a government stock.

• Mismatching:

• A requirement to match assets and liabilities by currency.
• A requirement to hold a mismatching reserve.
• A limit on the extent to which mismatching is allowed at all.
• Restrictions on the maximum exposure to a single counterparty
• Might require custodianship of assets.

Question 7

Immunisation

Answer 7

Used to achieve asset-liability matching.

Question 8

Discretionary benefits

Answer 8

Payments that are payable at the discretion of the provider.

For example, future bonus payments under with-profit contracts or pension increases in excess of guaranteed contracts.

Question 9

8 Examples of institutional liabilities for a General Insurer

Answer 9

Motor policies:

• property damage
• bodily injury
• liability for property damage / bodily injury to 3rd parties

Employer’s liability policies:

• Property damage
• Bodily injury / disease / death

Other products:

• Household property (contents, buildings)
• Commercial property
• Product liability

Question 10

8 Examples of institutional liabilities for a Life insurer

Answer 10

Non-profit:

• Life cover (eg term / whole life assurance)
• Annuities

Unit-linked:

• Unit fund
• Non-unit fund

With-profits:

• Sum insured
• declared reversionary bonus
• future reversionary bonuses
• future terminal bonus

Question 11

Appropriate Assets for liabilities guaranteed in money terms

Answer 11

fixed interest assets.

Question 12

Approaches to matching liabilities guaranteed in money terms

Answer 12

• Pure Cashflow Matching
• Approximate matching:
  ……- Immunisation
  ……- Liability hedging

Question 13

3 Conditions of Immunization

Answer 13

• Equal present values
• Equal durations
• Asset portfolio convexity > liability convexity

Question 14

Main limitation of Immunization ito. changing interest rates:

Answer 14

Provides protection against parallel yield curve shifts, but not against twists or other non-parallel movements.

Question 15

Appropriate Assets for liabilities guaranteed in terms of an index

Answer 15

Index-linked securities, where available

If not available:

• equity type assets
• assets expected to produce a real return

Question 16

Appropriate assets for discretionary benefits liabilities

Answer 16

Aim is to maximise benefits and/or meet expectations.

Investing to produce highest expected return and/or smooth returns.

Question 17

Net liability outgo in insurer/pension scheme consists of:

Answer 17

benefit payments
+ expense outgo
- premium / contribution income

Question 18

Workings of a mismatching reserve

Answer 18

The regulations are usually framed so that the more a company decides to invest in riskier assets with a higher expected return, the higher is any resulting reserve.
This increases the value of the liabilities and reduces the available free assets/surplus.